Pay IRA penalty or foreclose?

Dear Tax Talk,
I have been unemployed for 11 months now and my home mortgage is in severe default with foreclosure proceedings in the near future. The mortgage company has denied mortgage assistance options.

My home is valued at approximately $225,000 -- with a mortgage payoff of approximately $34,000 -- so obviously I cannot allow foreclosure to occur. Selling our home is not an option.

Our only option at this time to avoid foreclosure is to withdraw money from several IRA and 401(k) plans to completely pay off the mortgage.

I have researched the exceptions for the 10 percent tax penalty on the Internet, as we are both under the age of 59½, and none of them seem to fit our situation.

Is there any way we can avoid the 10 percent tax penalty for early withdrawal?

Thanks in advance for your help.
-- Ralph

Dear Ralph,
You have to get as crafty as your bank if you want to come out on top. Obviously, with the amount of equity available in a foreclosure, your bank is not interested in striking a deal. You're also right in your research that there is no outright relief in your situation from the 10 percent penalty. But paying $3,400 in a penalty is a lot better solution than losing a $200,000 home.

There are some maneuvers that can help you avoid the 10 percent penalty. In order to do this correctly, you need to get some pieces moving quickly.

To get the bank off your back immediately, you can withdraw from your IRA tax-free for up to 60 days, provided you replace the money within that time. Without a job, this sounds difficult, but it may not be if you restructure your 401(k) account.

Chances are that you left your 401(k) with your previous employer. Since you no longer work for them, a plan loan is not an option. However, if you established a new business, that business can create a retirement plan for you from which you could obtain a plan loan. A loan is a perfect solution because it is not subject to penalty or income tax. In fact, you could use the loan to help start a new business, as the job hunt is apparently not panning out.

My suggestion then is use the money from your IRA to save your house immediately. Set up a new entity (an S corp) to start a new business with you as the boss. Create a new 401(k) plan for the business and roll over your prior employer's plan assets as soon as possible.

A competent stock broker can help you set up a retirement plan (it can't be SIMPLE IRA as loans are not allowed) at little or no cost that allows plan loans (specify this to the broker).

Before the 60 days are up, use the new 401(k) plan to make a loan for you and repay the IRA withdrawal. Borrow a little more to make the first few loan payments and/or to start your own business. You can borrow up to the lesser of one half of your account balance or $50,000. You can move remaining IRA assets to the new 401(k) to boost your borrowing limits.

The solution provided here is not all inclusive, so I suggest you consult a competent accountant for a full explanation of the consequences of following my plan given your particular circumstances.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.

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